Ruling on Motion to Escrow, October 28,1999

the proposed order of field-wide well spacing rules and the integration of interests
pursuant to Environmental Conservation Law (ECL) §§23-0501 and 23-0901 for the

GLODES CORNERS ROAD FIELD,
STEUBEN COUNTY, NEW YORK

RULING

on Motion to escrow proceeds of production or to shut-in production

File No.

DMN 99-1

(Glodes Cors. Rd. Field)

The Motion

With reference to the proceedings to establish field-wide spacing rules for natural gas and oil wells and to integrate interests within proposed spacing units in the Glodes Corners Road Field, the New York State Department of Environmental Conservation (the "Department") Division of Mineral Resources Staff (the "Staff") move for an Order to require the well field developer, Columbia Natural Resources, Inc. ("Columbia" or the "developer") (a) to immediately place the proceeds of production from its existing wells attributable to unleased parcels within the proposed spacing units in an interest bearing escrow account and (b)to pay royalties to its existing lessors based on the oil and gas lease agreements in effect, pending issuance of a final Order of the Commissioner; and (c) to subsequently distribute all such escrowed funds on the basis of the Commissioner's Order establishing the spacing units.

Alternatively, the Staff move for an Order, without further notice or proceedings, that (a) shuts in (i.e., stops) the production of oil or gas from all Glodes Corners Road Field wells draining oil or gas from beneath leased and unleased premises without fair and adequate compensation to the owners of the minerals; and (b) suspends the transportation of oil or gas products from Columbia's wells in the Glodes Corners Road Field.

Proceedings

Proceedings on this motion occurred concurrently with, but, as discussed below, separately from the publicly advertised well-spacing hearings. Please refer to the Rulings After Public Hearing being issued simultaneously herewith for a description of the proceedings attendant to the public hearings.(1)

The Staff's Motion was served upon Columbia on or about June 12, 1999. On June 18, 1999, Columbia responded to the Staff's motion, requesting that it be denied. On July 6, 1999, the Staff filed a request for permission to respond to Columbia's June 18, 1999 response. Permission was granted on July 8, 1999. On July 14, 1999, Columbia requested permission to file a response to Staff's papers when filed. This request was denied July 22, 1999, because the Staff, as movant, had the burden of persuasion. However, leave was granted for Columbia to renew its request after the Staff's papers were filed, based on their contents. To date, the Staff have not filed a response to Columbia's June 18, 1999, response.

Summary of Positions

ECL § 23-0301 (Declaration of policy) states:

"It is hereby declared to be in the public interest to regulate the development, production and utilization of natural resources of oil and gas in this state in such a manner as will prevent waste; to authorize and to provide for the operation and development of oil and gas properties in such a manner that a greater ultimate recovery of oil and gas may be had, and that the correlative rights of all owners and the rights of all persons including landowners and the general public may be fully protected ..."

With reference to ECL §23-0301, the Staff say that the Department has a responsibility "to ensure that owners affected by production from beneath their property are compensated in a fair and reasonable manner. " To this end, the Staff drafted a stipulation [Hearing Exhibit 6(B)] under which Columbia would escrow royalty payments attributable to unleased parcels and would pay royalties to existing lessors out of proceeds from its wells pending the issuance of a Final Commissioner's Order. However, because Columbia would not agree to the draft stipulation, the Staff now make their motion to "protect correlative rights" while the well-spacing proceeding is pending. The Staff say that their request is a fair and equitable interim measure that will not harm Columbia.

As alternative relief, the Staff seek an order pursuant to ECL § 23-0305(8)(g) that "shuts in" all production, contending that a failure by Columbia to escrow proceeds is contrary to § 23-0301's requirements, and that staying recovery of the resource pending a Final Order protects correlative rights.

Columbia says that the Staff failed to provide any authority to order the escrow of royalty proceeds, noting that ECL § 23-0301 states general policy but does not confer power. Columbia says that it could not agree under the Staff's draft stipulation to limit production from existing wells until 75% of the owners in the proposed units are under lease because, under its existing leases, it is unable to modify the existing units to distribute royalties to the owners of the tracts that would be included in the proposed units. Columbia says such an action would jeopardize its interest in the leases and wells. Columbia points out that if it were required to both observe the contractual obligations of its leases and make the proposed escrow payments, it would pay total royalties far in excess of the required 1/8 of the proceeds. Columbia says it would be unable to recoup the royalties under the valid existing units. Columbia contends that the Staff's request would cause an unfair hardship and deprive Columbia of a fair return on its investment. Columbia argues that the Staff's request would make the Commissioner's Final Order retroactive, while the proposed stipulations only contemplate a prospective effect.

Columbia claims that the motion ignores the procedures for notice and hearing in ECL §23-0901. Columbia questions the need to "protect" the unleased owners when they have been offered the opportunity to lease with Columbia, have refused for their own personal reasons, but still may enter into leases with other operators or drill their own wells. Columbia argues that the relief would eliminate the range of remedies the owners already have. Columbia contends that the Staff's claim that the correlative rights of unleased owners are not being protected is premature and is a factual issue to be determined with reference to the Final Order.

Columbia argues that "shut-in" under §23-0305(8)(g) may only be ordered when a rule, regulation or order is being violated. Columbia contends that the Staff did not allege that Columbia had violated any rule, regulation or order, and that Columbia could not violate ECL §23-0301 because the section is a policy statement that the Department must follow. In addition, Columbia contends that a "shut-in" would adversely affect the "correlative rights" of its lessors by cutting off their monthly royalty checks and free gas. In addition, Columbia argues that a "shut in" would deny Columbia investment return and the time value of monies, increase its costs to meet contractual obligations to customers, and risk damage to its equipment.

Lastly, Columbia points out that even if it's assumed that the Staff have met their burden of proof on the instant motion, the Staff failed meet the procedural requirements of 6 NYCRR §550.4 and ECL §23-0305(2) to provide notice and hearing on the proposal to escrow royalty proceeds or shut-in the field pending a Final Order.

Discussion

Procedural defect:

As a threshold matter, with regard to orders in the administration of ECL Article 23, ECL §23-0305(2) provides that "[n]o rule, regulation, order or amendment thereof, except in an emergency, shall be made by the department without a public hearing upon at least ten days' notice, exclusive of the date of service. The public hearing shall be held at such time and place as may be prescribed by the department and any interested person shall be entitled to be heard." Similarly, 6 NYCRR §550.4 (a) provides that "[e]xcept as hereinafter provided, the department will promulgate no rule, regulation, order or amendment thereof, except in an emergency, without a public hearing upon at least 10 days notice, exclusive of the date of the service." Here, there was neither public notice nor a hearing on the Staff's motion. In the proceeding in chief, the notice given was for a public hearing on a proposal "to establish field-wide rules for the spacing of oil and gas wells, and to order the integration of interests within the resulting spacing units" (see the Notice of Hearing, Hearing Exhibit 1). The Notice of Hearing did not mention that the Staff would move for an interim order and was silent on a potential "shut-in" of production. Since the Staff's proposed "shut-in" could disrupt Columbia's lessors' monthly checks or free gas (i.e., their property interests), I conclude that the persons who could be affected should have been afforded an opportunity to be heard on the issue. The lack of public notice and hearing precludes, for now, making the requested order.

Legal authority for an interim order re proceeds and royalties:

I am aware of only four other proceedings before this Office which involved the escrow of royalties pending final orders in well spacing proceedings: Stagecoach Field (Commissioner's Decision and Order, 9/24/93); Gailbert Explorations/Desert Gas Exploration Co., Inc. (Commissioner's Order, 8/20/85); Miller Brewing Co. (Commissioner's Decision, 8/10/79); and Gordon Brook Natural Gas Pool (Commissioner's Order, 5/19/78). In Stagecoach and Gordon Brook, escrow was by agreement of the affected parties. In Miller Brewing, there was an escrow of the royalties payable to the lessors; whether by agreement or direction was not set forth . In Gailbert, escrow was directed through an Interim Ruling by the administrative law judge as a condition to the developer receiving permission to perform production testing of a well, and applied to royalties payable under existing leases. Here, the proposed escrow is neither voluntary, nor a condition to the developer receiving a requested benefit. The funds to be placed in escrow are not the lessors' royalty interests (since the Staff propose that they are to be paid), but a portion of the proceeds that otherwise would go to the developer. Thus, none of these earlier cases seem to fit what the Staff now propose.

In New York, the common law is that gas and oil are produced under the rule of capture and belong to the producer who first gets them out of the ground. Application of Republic Light, Heat and Power Co., 265 AD 74, 38 NYS2d 302 (1942). Ownership of the gas and oil beneath one's land is not absolute. This rule is different from the rule for solid minerals, where the owner of the land has absolute ownership of the minerals within. The rule of capture is followed for gas and oil because, like wild animals, these substances migrate. Thus, under the common law an owner has the right to capture gas and oil on his property, even if the end result is to deplete what is on neighboring properties. See Wagner v Mallory, 169 NY 501, 505 (1902). Simply put, at common law all landowners have a right to capture all the gas and oil that they can from their properties, regardless where the substances may migrate from -- and what they capture is theirs.

Landowners typically do not exercise their rights to capture gas by drilling their own wells. Rather, they lease these rights to others who have the financial and technical resources to take on such projects in return for a portion of what is produced. In effect, the right to capture then becomes divided into a "royalty interest" for the landowner lessor (typically 1/8 of the value of the gas produced, free and clear of production expenses), and a "working interest" for the operator lessee (typically 7/8 of the value of the gas produced, subject to all costs of exploration and development). See Manual of Oil and Gas Terms, 10th Ed., Williams and Meyers.

Assuming a typical situation here, Columbia has acquired from its lessors (the land owners) their rights to capture gas. Under common law, the gas that Columbia produces then belongs to Columbia. By agreement, Columbia owes the landowners 1/8 of the value of what it produces, free and clear (their "royalty interest") -- regardless of where the gas may have migrated from. Columbia takes the remaining 7/8 subject to the costs of exploration and development (its "working interest").

The Staff now propose that Columbia continue royalty payments to its lessors in accordance with their leases (i.e., Columbia would continue to pay its lessors their full royalty interest as agreed). However, Columbia would also be required to place in escrow all proceeds "attributable to" unleased parcels within each proposed spacing unit. This can only come out of Columbia's working interest. Ultimately, some of Columbia's working interest will be paid out of escrow as "royalties" to owners of the unleased parcels in the proposed spacing unit. While Columbia would have received valuable consideration (the right to capture gas) from its lessors in return for royalties, Columbia will have received nothing for what is paid to the owners of the unleased parcels. Since the proceeds belong to Columbia under common law, there would have to be something in the statute that clearly authorizes this result. "The common law is never abrogated by implication, but on the contrary it must be held no further changed than the clear import of the language used in a statute absolutely requires." McKinney's Statutes, §301(b). "Statutes which increase common law liabilities or which create new liabilities must be strictly construed." Id., §301(c).

The Staff cite a responsibility to protect "correlative rights" as the basis for their motion, however, the statute neither confers nor defines "correlative rights," but, rather, implies that these are rights which already exist. I note that ECL §23-0301 ("Declaration of policy"), §23-0305 ("Powers and duties of the commissioner and the department"), and §3-0301 ("General functions, powers and duties of the department and the commissioner") do not seem to address the action that the Staff is requesting. At present, in my view, there is an insufficient basis upon which to recommend to the Commissioner that the relief requested by the Staff be granted. For the above stated reasons, the motion is denied without prejudice.

If Staff would like to renew its motion upon public notice and hearing, it needs to clarify the authority for making an order.

Shut-In:

ECL §23-0305(8)(g) authorizes the Department to order "suspension of drilling or production operations whenever such operations are being carried on in violation of this article [Article 23] or any rule or regulation promulgated thereunder or order issued pursuant thereto." While ECL §23-0301 is cited as the provision allegedly violated, the provision imposes no requirement of its own regarding drilling or production operations. Rather, the provision declares that it is in the public interest that such operations be regulated to achieve particular results. The duty imposed by this section is on the Department, not the developer. Therefore, there is no violation upon which to base a "shut-in" order.

Ruling

For the reasons stated above, the Staff's motion is denied without prejudice to the Staff renewing same upon proper notice with hearing.

Appeals

Any appeal of the determinations herein must be filed with the Commissioner in writing, to be received at the address below no later November 15, 1999. Copies of the appeal must also be sent in the same manner to the ALJ and the attorneys for the Department Staff and Columbia. Replies must be filed no later than November 29, 1999.

Appeals to the Commissioner are to be sent to the following address: Commissioner John P. Cahill, c/o James H. Ferreira, Assistant Commissioner, New York State Department of Environmental Conservation, 50 Wolf Road, Albany, NY 12233-1550. (See the Service List attached for other addresses).